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What could be more perfect than a Krispy Kreme doughnut? Hot from the fryer and loaded with sugar, the Original Glazed is practically irresistible. For a time, Krispy Kreme’s stock seemed irresistible, too. When the company went public in April 2000, at the peak of the Internet whirlwind, investors flocked to buy into a business they could understand. An old-fashioned franchise based in Winston-Salem, North Carolina, Krispy Kreme Doughnuts Inc. boasted solid fundamentals, adding stores at a rapid clip and showing steadily increasing sales and earnings.

But Krispy Kreme also had a mystique. Its doughnuts, available for many years only in the Southeast, had attracted a devoted, even fanatical, customer base. When the company decided to go national, it opened franchises in locations guaranteed to generate buzz — Manhattan, Los Angeles, Las Vegas — and customers lined up around the block. By August 2003, KKD was trading at nearly $50 on the New York Stock Exchange, up 235 percent from its initial public offering price of $21 on Nasdaq, and Fortune magazine was calling Krispy Kreme the “hottest brand in the land.” For the fiscal year ended in February 2004, the company reported $665.6 million in sales and $94.7 million in operating profit from its nearly 400 locations, including stores in Australia, Canada, and South Korea.

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And then, just as rapidly as its popularity spiked, Krispy Kreme pitched into a steep downward spiral that may yet end in bankruptcy. The company’s woes surfaced in May 2004, when then-CEO Scott Livengood blamed low-carbohydrate diet trends for Krispy Kreme’s first-ever missed quarter and first loss as a public company. That raised analysts’ eyebrows, as blaming the Atkins diet for disappointing earnings carried a whiff of desperation.

The Securities and Exchange Commission came knocking in July 2004, making an informal inquiry into Krispy Kreme’s buybacks of several franchises. As the stock price plunged, shareholders filed suit. Franchisees alleged channel stuffing, claiming that some stores were getting twice their regular shipments in the final weeks of a quarter so that headquarters could make its numbers. The SEC upgraded its inquiry to “formal” status in October 2004. Average weekly sales, a key retailing measure, fell even as the company continued to add stores. In January 2005, Krispy Kreme decided to restate its financials for much of fiscal 2004. Livengood was replaced as CEO by turnaround specialist Stephen Cooper, who also kept his other job: interim CEO of Enron Corp.

The following month, the company announced that the United States Attorney’s Office of the Southern District of New York was also joining the fray — a move indicating concern about possible criminal misconduct. In April, Cooper shored up the business by securing $225 million in new financing. The company announced that it expected a loss for its latest quarter, and warned investors not to rely on its published financials for fiscal 2001, 2002, and 2003, and the first three quarters of fiscal 2005, in addition to those for 2004. By early May, Krispy Kreme still hadn’t filed its restated financials, and its shares were trading around $6.

What went wrong? How could a company in business for nearly 70 years, with an almost legendary product and a loyal customer base, fall from grace so quickly? The story of Krispy Kreme’s troubles is, at bottom, a case study of how not to grow a franchise. According to one count, there are at least 2,300 franchised businesses in the United States, and many are extremely successful. But there are pitfalls in the franchise model, and Krispy Kreme — through a combination of ambition, greed, and inexperience — managed to stumble into most of them.

Aggressive Growth

From its humble beginnings in 1937 as a family-owned business, Krispy Kreme slowly enlarged its footprint in the Southeast. In 1976, three years after founder Vernon Rudolph died, the company was sold to Beatrice Foods Co.; in 1982, a group of franchisees bought it back. In 1996, the company began to stake its claim as a national franchise.

But once Krispy Kreme went public, “there was enormous pressure, as there is for all companies, to grow very quickly and sustain growth quarter after quarter after quarter,” comments Steven P. Clark, an assistant professor of finance at Belk College of Business at the University of North Carolina at Charlotte. Unfortunately, adds Clark, “this was not the sort of business that was going to have that kind of unending growth.”

McDonald’s Corp. is the gold standard in franchising, driving such profitability to individual restaurants that franchisees are eager to join the system and follow the company’s stringent operating guidelines. But Krispy Kreme concentrated on growing revenues and profits at the parent-company level, while its outlets struggled. “You can often get a system to grow really large even when particular outlets aren’t really profitable,” notes Scott Shane, SBC Professor of Economics at Case Western Reserve University’s Weatherhead School of Management and an expert on franchising. Franchises, he explains, suffer from “goal conflict”: while the franchisor aims to maximize sales, and thus boost royalty payments, the franchisee needs to maximize profits. If a franchisor packs a market with outlets to boost its own growth, it hurts the system in the long run by forcing units to compete with one another.

“You might add another outlet in a market and increase your sales by 50 percent, but you might have turned franchisees in that market from profitable to unprofitable,” says Shane. Thus Krispy Kreme reported nearly a 15 percent increase in second-quarter revenues from fiscal 2003 to fiscal 2004, but same-store sales were up just a tenth of a percent during that time. The waning of a fad? Perhaps. But citing the issue of “significantly declining new unit returns” in August 2004, J.P. Morgan analyst John Ivankoe wrote: “These returns declined as [the] incremental appeal of each new retail store fell upon market penetration.” A year earlier, Ivankoe had downgraded the stock from “neutral” to “underweight,” the equivalent of a “sell” rating.

Getting Greedy?

Having to share markets with other outlets isn’t the only handicap for franchisees. In addition to the standard franchise fee and royalty payments, Krispy Kreme requires franchisees to buy equipment and ingredients from headquarters at marked-up prices. This strategy, while not unheard of, can hurt franchisees in the long run.

“There are a couple of ways that franchise companies can look at the selling of equipment and formula,” says Steve Hockett, president of FranChoice Inc., a company that matches potential franchisees with franchisors. “One is that it’s a true profit center, even to the point where companies can be aggressive on pricing. But most successful franchise companies build their business around the royalty payment; they don’t build it around equipment sales.” Over time, says Hockett, “the franchisor is more likely to succeed by building profitable franchisees that can make royalty payments.”

Krispy Kreme, on the other hand, raked in $152.7 million — 31 percent of sales in 2003 — through its Krispy Kreme Manufacturing and Distribution (KKM&D) division, which sells the required mix and doughnut-making equipment. With initial equipment packages selling for $400,000, KKM&D can have operating margins of 20 percent or greater. But what’s good for the franchisor’s bottom line isn’t necessarily good for the franchisee’s. “[Raw ingredients and equipment] are sold to franchisees at what [is] an exceptionally high margin…. It is difficult to say how much this margin needs to drop to support franchise operations, but it must,” wrote Ivankoe in an August 2004 report.

The Thrill Is Gone

In its quest for growth, Krispy Kreme also squandered some of its mystique. “They became ubiquitous,” says Jonathan Waite, an analyst for KeyBanc Capital Markets in Los Angeles. “Not just in sheer numbers of restaurant units, but also roughly half of their sales started going to grocery stores, gas stations, kiosks. Anywhere that consumers could be found, you could find a Krispy Kreme.”

In what amounted to an act of heresy to Krispy Kreme devotees, the company also added smaller “satellite” stores that didn’t actually make doughnuts. Unlike its factory-style franchises where customers could watch as the pastries were showered in glaze — “doughnut-making theater,” the company called it — some new stores offered doughnuts that had been made elsewhere. Other products were added to the menu, too, including a line of high-carb, high-calorie frozen drinks, or “drinkable doughnuts,” as people dubbed them.

Straying further from the appeal of its key product, in May 2004 the company announced that it was developing, of all things, a sugar-free doughnut, in response to the popularity of low-carb diets. (The sugarless doughnut has yet to be rolled out, however, and the new management team is reviewing the concept.)

Fudging the Numbers

As Krispy Kreme pursued its ambitious growth strategy, it was making missteps in the finance department as well.

Except for the company’s plan to finance a $35 million mixing plant in Illinois with an off-balance-sheet synthetic lease — a plan the company scuttled in February 2002, in the face of post-Enron suspicions — Krispy Kreme’s accounting seemed unremarkable until October 2003. That’s when the company reacquired a seven-store franchise in Michigan, called Dough-Re-Mi Co., for $32.1 million. The company booked most of the purchase price as an intangible asset called “reacquired franchise rights,” which it did not amortize, contrary to common industry practice. Krispy Kreme had also agreed to boost its price for Dough-Re-Mi so that the struggling franchise could pay interest owed to the doughnut maker for past-due loans. The company then recorded the subsequent interest payment as income.

Krispy Kreme also rolled into the price the costs of closing stores and compensating the operating manager and principal owner of the Michigan franchise to stay on as a consultant. Both of these expenses became part of the intangible “reacquired franchise rights” asset on the company’s balance sheet, rather than costs that would have reduced the company’s reported earnings. Krispy Kreme announced in a December 2004 8-K filing that it will need to make a pretax adjustment of between $3.4 million and $4.8 million to properly record the compensation as an expense. A second adjustment of some $500,000 will reverse the improper recording of interest income.

Krispy Kreme’s repurchase of its northern California stores from a group of investors is also under scrutiny. In February 2004, the company paid $16.8 million to buy the 33 percent of Golden Gate Doughnuts LLC it did not already own. One of the beneficiaries of the buyout was the ex-wife of CEO Scott Livengood. The company failed to disclose this fact, although Adrienne Livengood’s stake was valued at approximately $1.5 million. While the decision not to reveal the connection looks bad, “this is only a significant legal issue if it somehow could be established that [Livengood] was seeking some kind of personal profit or gain through his ex-wife, as opposed to truly serving the company’s interest,” says Carl Metzger, a partner with Goodwin Procter LLP in Boston.

In its December 8-K, Krispy Kreme revealed that there would need to be adjustments made to the accounting for the Golden Gate Doughnuts purchase as well — a total of $3.5 million to correct improperly recorded compensation expenses and management fees that had been included in the purchase price. The company will also make a similar correction to fix errors made in the acquisition of a franchise in Charlottesville, Virginia.

On top of the questionable accounting and the lack of disclosure, Krispy Kreme may have paid inflated prices for some of the franchises it bought back. In 2003, the company spent $67 million to repurchase six stores in Dallas and rights to stores in Shreveport, Louisiana, that were owned in part by former Krispy Kreme board member and chairman and CEO Joseph A. McAleer Jr. Another longtime director, Steven D. Smith, was also part owner. Compared with the $32.1 million paid for the Michigan stores that same year, the number sounds high — $11.2 million versus $4.6 million per store. A civil suit filed by another former franchisee alleges that a higher bid was offered but ignored.

“I asked a lot of questions about why they paid so much for those acquisitions,” says one analyst. “I don’t think I ever truly got an answer. They told me it was a different time in terms of valuation, but those were pretty exorbitant prices.” The SEC, presumably, will insist on an answer in the course of its investigation.

Who Minded the Store?

The company’s own investigation, as detailed in an April notification to the SEC, has turned up accounting problems in other areas, too, involving derivatives, leases, equipment sales, and the consolidation of a bankrupt subsidiary. Even if these turn out to be mostly peccadilloes, they raise a question: Who was minding the store in the finance department?

As it turns out, a lot of people. From 2000 to 2004, Krispy Kreme employed three different CFOs. John Tate joined just after the company went public, in October 2000, after 18 months at kitchenware retailer Williams-Sonoma Inc. Tate was promoted to chief operating officer in 2002, and Randy Casstevens, the company’s longtime controller, took the top finance spot. Casstevens, who had spent most of his career at Krispy Kreme, had never been CFO of a public company before. After adding the chief governance officer role to his duties, Casstevens left in December 2003 in a move he then called “purely voluntary,” just five months before the company announced its first earnings miss. (Now working as a career counselor at Wake Forest University in Winston-Salem, Casstevens declined to be interviewed for this story.)

To replace Casstevens, Krispy Kreme brought in current finance chief Michael Phalen, who had worked with Krispy Kreme as an investment banker for CIBC World Markets and Deutsche Banc Alex. Brown, but had never held a CFO post before. The company declined to make Phalen available for an interview. John Tate, meanwhile, departed in August 2004, and is now the operations head at Restoration Hardware, working once again with his former boss from Williams-Sonoma. Tate did not return phone calls for comment.

Company watchers come to different conclusions about the meaning of the CFO churn. Ric Marshall, chief analyst at governance watchdog The Corporate Library, says the turnover may mean the CFOs were trying to raise red flags about the company’s financial state. “To me, this says the real numbers the CFOs were coming up with were numbers that the rest of management didn’t want to hear. They were looking for a CFO who was going to tell them good news.” Adds Goodwin Procter’s Metzger, “It may be that a particular CFO is the one who brought these issues to the company’s attention. You just don’t know.” But the fact that Tate and Casstevens were both promoted before leaving indicates that they were on good terms with the board and their fellow managers. All three CFOs answered to Livengood, whose 27 years at the company gave him far greater tenure than any of the finance chiefs.

Stephen Mader, vice chairman of executive recruiter Christian & Timbers, says the CFOs simply may not have been up to the task of guiding a high-growth franchise through the public markets. “This happens a lot with companies that enter the public arena that had done well under earlier conditions, but don’t have the experience in the public markets,” he says. “You could simply have nothing more here than a lot of marginal competence for running a company of that magnitude.”

Current finance chief Phalen “is a capable guy,” comments Waite. “If you look at his compensation structure, it’s mainly stock options. He has incentive to get the ship righted.” But Mader is less optimistic about the CFO’s chances. “It’s very rare to take a company into bankruptcy or a turnaround phase and hold on to the existing CFO to do it,” he says. “You need someone with no baggage, no sacred cows, who can look at things with objectivity.”

A Missing Ingredient

When Krispy Kreme was a fast-growing private company, it was easy to conceal weaknesses in management and corporate governance. But those weaknesses were magnified by the pressures of the public markets, particularly when the company’s growth strategy started to stumble, says Marshall. “When you don’t have a fully independent board holding management responsible for operational and strategic shortcomings, a machine moving that quickly is going to fall apart,” he says. “They really weren’t able to sustain the growth rate.”

Until recently, Krispy Kreme’s board was stocked with insiders left over from the company’s days as a private business, including some, like McAleer and Smith, who owned franchises. And until early 2002, the company maintained a fund through which 35 executives could invest in franchisees, potentially creating conflicts of interest. Management elected to dissolve the fund as part of a push to improve governance.

In another questionable move, in 2003, Krispy Kreme purchased Montana Mills Bread Co., a bakery-café chain at which Tate, then chief operating officer, was a director. Tate has said he was not involved in discussions about the transaction. Krispy Kreme put Montana Mills up for sale a year later, after paying approximately $40 million in stock for the business and then recording a $34 million charge upon closing most Montana Mills stores. Together with the problematic franchise buybacks, the transaction smacks more of an insider deal than simple incompetence.

A further warning sign of weak governance was the outsized compensation package awarded to former CEO Livengood, says Marshall. Livengood’s total compensation was more than 20 percent greater than the median for similar-size companies, according to The Corporate Library. Despite the company’s decline, Krispy Kreme’s board allowed Livengood to retire with a six-month consulting position that will pay him $275,000. He holds $1.7 million in options in addition to nearly 100,000 shares of Krispy Kreme stock. Livengood also continues to receive health benefits through the company, but he will no longer have use of the company jet, since one of new CEO Cooper’s first moves was to sell off the aircraft lease.

“When we see patterns of excessive compensation, that is usually an indicator that the board is not sufficiently independent,” says Marshall. As a result of the board’s coziness, he says, no one stepped in to challenge Krispy Kreme’s move away from the fresh-doughnut model, and no one questioned the aggressive accounting for franchise buybacks. “It was a classic governance failure,” sums up Marshall.

A Fresh Start

Although Krispy Kreme today looks like a company becalmed, if not sinking, some observers believe it will regain momentum. “Krispy Kreme as a company still has a lot of value in its name and in its product,” says attorney Metzger. “There should be a way for the company to continue to grow the business.”

With the January 2005 replacement of Livengood with Cooper, the revamped board — in which 8 of 10 directors are fully independent, according to The Corporate Library — has shown it is serious about making a turnaround. Since his arrival, Cooper has lined up $225 million in new debt financing led by Credit Suisse First Boston, Silver Point Finance, and Wells Fargo Foothill Inc. to help Krispy Kreme meet its immediate cash-flow needs. Cooper also announced a cost-cutting program that includes a 25 percent reduction in head count.

UNC’s Clark suggests the company may need to go private or sell itself to another large chain, like McDonald’s. “But I’m not sure that buyers are exactly lining up at the door,” he adds. KeyBanc’s Waite calls an acquisition doubtful, in part because he says the company is “not terribly cheap,” given the amount of work needed to get it back on track. Indeed, Waite hasn’t ruled out the possibility of bankruptcy. “The biggest thing they have to do is bring on an operator,” he says. “They need an industry insider who can stem the drop in sales at the unit level — somebody who knows how to drive organic sales growth.”

Ultimately, Krispy Kreme needs to get back to what fueled its phenomenal growth in the first place: really good doughnuts. “They need to emphasize the hot-doughnut experience,” says Waite, “rather than the cold, old doughnut in a gas station.”

Kate O’Sullivan is a staff writer at CFO.

Half-Baked
Krispy Kreme first reported solid growth, but has since announced that its results for 2001-2005 are not reliable.

2002

2003

2004

Total revenue*

$394.4

$491.6

$665.6

Net Income*

$26.4

$33.5

$57.1

Total long-term debt*

$3.9

$62.4

$146.2

Number of stores

218

276

357

Note: Figures for fiscal years ended in February
*in $ millions
Source: www.krispykreme.com